Personal injury settlements are usually not taxable for income tax because the money is often paid in settlement of only pain and suffering, medical bills, and property damage. However, money paid in settlement of a personal injury claim may be paid in compensation of numerous other types of damages.
When some of the money is paid in settlement of other types of damages, those portions of the personal injury insurance settlement or even the entire settlement amount may be taxed depending on what the settlement money was paid for.
This article will help you identify when is a personal injury settlement taxable.
Taxation of personal injury settlements is a topic on which I can write quite a few pages. However, I will attempt to give a simpler, general answer here in just a few paragraphs.
Of course, you should not rely on the information here and you should consult a CPA, accountant, or tax professional regarding your specific circumstances before settling your personal injury case or before filing your tax return if you already settled your case by signing a release.
What Is the IRS Law That Says Whether a Personal Injury Settlement Is Taxable?
IRC section 104(a)(2) addresses income exclusions for taxing personal injury lawsuit settlement payments.
When Is a Personal Injury Settlement Not Taxable?
Property Damage
Money paid for property damage is not taxable because it is offset by a loss.
If your car was damaged and the amount to repair it is $1,000, then your car is worth $1,000 less than it was prior to the accident. If you receive a settlement payment of $1,000 from an insurance company (or the person who caused the damage), you did not gain anything. You’re financially in the same position that you were before the damage.
Note: It does not matter whether you repair your car or keep the $1,000. In either event, you do not have to pay income tax on the $1,000.
Medical Bills
Also because it is offset by a loss, money paid for medical bills is not taxable if the medical bills paid have not been deducted from income as an itemized deduction.
Pain and Suffering
Likewise, money paid for “pain and suffering” in the settlement of a personal injury claim is not taxable because it is compensation for a loss that is intended to make you whole again.
When is money paid to settle a personal injury claim taxable?
Emotional Distress, Mental Anguish – Psychological Injuries
Money paid for psychological injuries may or may not be taxable.
The U.S. Court of Appeals for the District of Columbia in Murphy and Leveille, Appellants v. IRS and USA, Appellees, reversed a decision that money paid for psychological injuries is not taxable.
The court ruled that the personal injury award Ms. Murphy received was “within the reach of the congressional power to tax under Article I, Section 8 of the Constitution”, even if the award was “not income within the meaning of the Sixteenth Amendment”. The U.S. Supreme Court denied review of the decision on April 21, 2008.
But IRS Publication 4345 (Rev. 11-2021) provides that under certain conditions, money paid for emotional distress or mental anguish is not taxable. IRS Publication 4345 states, “The proceeds you receive for emotional distress or mental anguish attributable to a personal physical injury or physical sickness are treated the same as proceeds received for Personal physical injuries or physical sickness above.”
Note that IRS Publication 4345 says it must be attributable to a personal physical injury. Otherwise, emotional distress and mental anguish are taxable.
Lost Wages/Lost Income
Money paid for lost income due to personal injury is not taxable.
However, IRS Publication 4345 (Rev. 11-2021) states, “If you receive a settlement in an employment-related lawsuit; for example, for unlawful discrimination or involuntary termination, the portion of the proceeds that is for lost wages (i.e., severance pay, back pay, front pay) is taxable wages and subject to the social security wage base and social security and Medicare tax rates in effect in the year paid.”
When Is a Personal Injury Settlement Taxable?
Punitive Damages
Money paid for punitive damages is taxable. IRC section 104(a)(2) was amended in 1996 making punitive damages taxable without regard to their connection to a physical or nonphysical injury or sickness.
Confidentiality Clause
There is no exemption in the tax code for taxation of payments for confidentiality. Consequently, a payment made for confidentiality is taxable as ordinary income.
The allocation of how much is paid for pain and suffering and how much is paid for confidentiality should be identified in the settlement release and explained as to how and why the allocation was determined.
If you have a confidentiality clause in your release, you must address the apportionment in the release or the IRS or court will determine how much is paid for confidentiality which is taxable income.
A mutual promise, by both the plaintiff and defendant, of confidentiality may eliminate the need to allocate how much is paid for confidentiality, especially if it is described why the confidentiality is needed to be mutual. When mutual, the promise of confidentiality is exchanged for the other side’s promise of confidentiality, not for money.
If the release requires confidentiality and does not identify the amounts paid in settlement of personal injury and for confidentiality, the IRS will be able to determine the amount.
The plaintiff should actually be paid for confidentiality in addition to the amount desired for pain and suffering and other damages because the plaintiff will have to pay income tax on the amount paid for confidentiality.
Interest Earned after a Personal Injury Settlement
If you receive money for a personal injury settlement that is not taxable and you deposit the money in a savings account, bank account, or otherwise invest it so that you earn interest payments, the interest earned is taxable.
How to Keep Public Benefits When Receiving a Personal Injury Settlement
Plaintiffs who receive public benefits such as Medicaid and do not want to lose those benefits must not deposit personal injury settlement money in a bank account and cannot earn taxable interest.
For plaintiffs who receive public benefits, the personal injury settlement can be deposited into a trust such as a Special-Needs Trust or Pooled Trust. The settlement check must be payable to the trust.
When a personal injury settlement is deposited in a Special-Needs Trust, the interest earned is not taxable.
For more information, see:
Special-Needs Trusts HelpWithLiens.com.
Pooled Trusts NYSARC
Guide to Special-Needs Trusts and Pooled Trusts
Money Awarded Pursuant to a Verdict After Trial
When money is awarded pursuant to a verdict after trial, the verdict will state how much money is paid for property damage, medical bills, lost wages, pain and suffering, etc.
The amount of your personal injury award which is subject to taxation by the IRS or state tax authority will be determined by the jury verdict.
Money Paid Pursuant to a Settlement
The problem is that when money is paid pursuant to a settlement, it is often not specified in the release what the money is being paid for.
It is possible for the IRS to make a determination by examining various papers in the file, such as the initial claim letter, the legal complaint, papers submitted to the insurance company as proof of damages, and the release which was signed.
The usual “General Release” form is silent on tax issues and thus not helpful. But it may be possible to solve this problem with proper wording in the settlement release.
It is therefore important to customize the release to address the tax issues. The provisions which result in a favorable tax status are often adverse to the insurance company’s interests, however, I have almost always been able to successfully include provisions in my clients’ release to prevent taxation of settlement proceeds.
Articles About Income Tax on Personal Injury Settlements
See this page for a list of articles about Income Tax implications on Personal Injury Settlements